Mid Cap vs Small Cap Funds — Two Steps Down, Two Different Rides

Listed companies are ranked by size and grouped into bands. Mid cap schemes invest mainly in the band just below the largest companies. Small cap schemes invest mainly in the companies below that, which is a much larger and more varied group. Our page on large, mid and small cap funds covers how the bands are defined.

Mid sized companies are often established businesses that have not yet reached the top tier. Small companies range from well-run firms early in their growth to businesses that may never become much larger.

That wider range of quality in the small company band is part of why selection matters more there, and part of why outcomes vary more.

Both move more than the largest companies. Small caps move more than mid caps.

In strong markets for smaller companies, both can rise sharply, with small caps often further. In weak markets both can fall hard, and small caps can fall further and take longer to recover. The ride is rougher at each step down.

This is not a flaw to be engineered away. It is the nature of holding businesses that are smaller, less established and more sensitive to conditions. Our page on risk and volatility explains why that movement only becomes a loss if you have to sell during it.

This is the difference people overlook, and it matters more than the category names suggest.

Shares in smaller companies trade less. Buying or selling a large quantity can move the price, and in a falling market it can be difficult to sell at all without accepting a much lower price.

For a scheme with a great deal of money, that constrains what the manager can do. Building a meaningful position in a small company takes time, and so does leaving one. Our page on fund size and AUM explains why some small cap schemes have limited or paused fresh subscriptions when they grew very large.

Mid cap schemes face a milder version of the same pressure.

Both categories are especially prone to money arriving at the wrong moment.

A strong run in smaller companies produces impressive recent figures, those figures attract new money, and that money arrives near the top. When the segment turns, the same investors leave near the bottom. The scheme may have done reasonably over a full cycle while many of its investors did badly.

Our post on why somebody else fund did better covers where these comparisons come from, and our page on how returns are calculated explains why a recent window flatters so easily.

Both need long horizons. Small caps need the longest.

A stretch in which smaller companies lag can last years, and somebody holding for a goal inside that stretch may simply run out of time. Money with a date within the next several years does not belong in either category, whatever recent performance looks like.

A practical approach many households take is a modest allocation to smaller companies within a broader equity holding, sized so that a poor stretch is disappointing rather than damaging. Our page on asset allocation covers setting that proportion.

Holding one of each is common and reasonable, provided you check what they actually hold.

The boundary between the bands moves as companies grow and shrink, and schemes may hold some companies near the edges of their band. Two schemes can end up with more in common than their names suggest, which our page on portfolio overlap covers.

A scheme that holds large and mid sized companies together by rule is another way to get mid cap exposure with a steadier base, as our page on large and mid cap funds explains.

Worth describing plainly, because the category descriptions rarely do.

A difficult period for smaller companies does not usually arrive as a single sharp fall that recovers within weeks. More often it is a long, grinding stretch in which the value drifts lower, rallies briefly, and drifts lower again, while larger companies do noticeably better. Each statement is a small disappointment, and they accumulate.

That is the experience that causes most people to leave, and they usually leave near the end of it rather than the beginning. Somebody who has held a small cap scheme through one such stretch knows whether they can do it again. Somebody who has not should assume it will be harder than they expect, and size the holding accordingly.

Continuing a SIP through that period is often the more useful response, since each instalment buys at the lower prices, as our page on rupee cost averaging explains. But that only works if the money is not needed during the stretch.

• Why now? If the answer is recent performance, that is a reason to be careful rather than a reason to buy.
• Is your horizon long enough to sit through several poor years?
• What share of your equity is this going to be?
• How large is the scheme, particularly for small caps?
• What did you do the last time something you held fell sharply?

We are distributors rather than investment advisers and we recommend no schemes. If you want to work out whether smaller companies belong in your plan and at what size, get in touch.